BANKING SYSTEM, BANKING HISTORY; FINANCIAL KNOWLEDGE, GREAT THINGS TO KNOW ABOUT THE AMERICAN BANKING HISTORY

COMMERCIAL BANKING -------KNOWLEDGEFINANCIAL.COM

The fundamental functions of a commercial bank during the past two centuries have been making loans, receiving deposits, and lending credit either in the form of bank notes or of "created" deposits. The banks in which people keep their checking accounts are commercial banks.

There were no commercial banks in colonial times, although there were loan offices or land banks that made loans on real estate security with limited issues of legal tender notes. In 1781 Robert Morris founded the first commercial bank in the United States—the Bank of North America. It greatly assisted the financing of the closing stages of the American Revolution. By 1800, there were twenty-eight state-chartered banks, and by 1811 there were eighty-eight.

Alexander Hamilton's financial program included a central bank to serve as a financial agent of the treasury, provide a depository for public money, and act as a regulator of the currency. Accordingly, the first Bank of the United States was founded 25 February 1791. Its $10 million capital and favored relationship with the government aroused much anxiety, especially among Jeffersonians. The bank's sound but unpopular policy of promptly returning bank notes for redemption in specie (money in coin) and refusing those of non-specie-paying banks—together with a political feud—was largely responsible for the narrow defeat of a bill to recharter it in 1811. Between 1811 and 1816, both people and government were dependent on state banks. Nearly all but the New England banks suspended specie payments in September 1814 because of the War of 1812 and their own unregulated credit expansion.

The country soon recognized the need for a new central bank, and Congress established the second Bank of the United States on 10 April 1816. Its $35 million capitalization and favored relationship with the Treasury likewise aroused anxiety. Instead of repairing the overexpanded credit situation that it inherited, it aggravated it by generous lending policies, which precipitated the panic of 1819, in which it barely saved itself and generated wide-spread ill will.

Thereafter, under Nicholas Biddle, the central bank was well run. As had its predecessor, it required other banks to redeem their notes in specie, but most of the banks had come to accept that policy, for they appreciated the services and the stability provided by the second bank. The bank's downfall grew out of President Andrew Jack-son's prejudice against banks and monopolies, the memory of the bank's role in the 1819 panic, and most of all, Biddle's decision to let rechartering be a main issue in the 1832 presidential election. Many persons otherwise friendly to the bank, faced with a choice of Jackson or the bank, chose Jackson. He vetoed the recharter. After 26 September 1833, the government placed all its deposits with politically selected state banks until it set up the Independent Treasury System in the 1840s. Between 1830 and 1837, the number of banks, bank note circulation, and bank loans all about tripled. Without the second bank to regulate them, the banks overextended themselves in lending to speculators in land. The panic of 1837 resulted in a suspension of specie payments, many failures, and a depression that lasted until 1844. -------------KNOWLEDGEFINANCIAL.COM

Between 1833 and 1863, the country was without an adequate regulator of bank currency. In some states, the laws were very strict or forbade banking, whereas in others the rules were lax. Banks made many long-term loans and resorted to many subterfuges to avoid redeeming their notes in specie. Almost everywhere, bank tellers and merchants had to consult weekly publications known as Bank Note Reporters for the current discount on bank notes, and turn to the latest Bank Note Detectors to distinguish the hundreds of counterfeits and notes of failed banks. This situation constituted an added business risk and necessitated somewhat higher markups on merchandise. In this bleak era of banking, however, there were some bright spots. These were the sulffolk Banking System of Massachusetts (1819–1863); the moderately successful Safety Fund System(1829–1866) and Free Banking (1838–1866) systems of New York; the Indiana (1834–1865), Ohio (1845–1866), and Iowa (1858–1865) systems; and the Louisiana Banking System (1842–1862). Inefficient and corrupt as some of the banking was before the Civil War, the nation's expanding economy found it an improvement over the system on which the eighteenth-century economy had depended.

Secretary of the Treasury Salmon P. Chase began agitating for an improved banking system in 1861. On 25 February 1863, Congress passed the National Banking Act, which created the National Banking System. Its head officer was the comptroller of currency. It was based on several recent reforms, especially the Free Banking System's principle of bond-backed notes. Nonetheless, the reserve requirements for bank notes were high, and the law forbade real estate loans and branch banking, had stiff organization requirements, and imposed burdensome taxes. State banks at first saw little reason to join, but, in 1865, Congress levied a prohibitive 10 percent tax on their bank notes, which drove most of these banks into the new system. The use of checks had been increasing in popularity in the more settled regions long before the Civil War, and, by 1853, the total of bank deposits exceeded that of bank notes. After 1865 the desire of both state and national banks to avoid the various new restrictions on bank notes doubtless speeded up the shift to this more convenient form of bank credit. Since state banks were less restricted, their number increased again until it passed that of national banks in 1894. Most large banks were national, however.

The National Banking System constituted a substantial improvement over the pre–Civil War hodgepodge of banking systems. Still, it had three major faults. The first was the perverse elasticity of the bond-secured bank notes, the supply of which did not vary in accordance with the needs of business. The second was the decentralisation of bank deposit reserves. There were three classes of national banks: the lesser ones kept part of their reserves in their own vaults and deposited the rest at interest with the larger national banks. These national banks in turn lent a considerable part of the funds on the call money market to finance stock speculation. In times of uncertainty, the lesser banks demanded their outside reserves, call money rates soared, security prices tobogganed, and runs on deposits ruined many banks. The third major fault was that there was no central bank to take measures to forestall such crises or to lend to deserving banks in times of distress. -----------------KNOWLEDGEFINANCIAL.COM

In 1873, 1884, 1893, and 1907, panics highlighted the faults of the National Banking System. Improvised use of clearinghouse certificates in interbank settlements some-what relieved money shortages in the first three cases, whereas "voluntary" bank assessments collected and lent by a committee headed by J. P. Morgan gave relief in 1907. In 1908 Congress passed the Aldrich-Vreeland Act to investigate foreign central banking systems and suggest reforms, and to permit emergency bank note issues. The Owen-Glass Act of 1913 superimposed a central banking system on the existing national banking system. It required all national banks to "join" the new system, which meant to buy stock in it immediately equal to 3 percent of their capital and surplus, thus providing the funds with which to set up the Federal Reserve System. State banks might also join by meeting specified requirements, but, by the end of 1916, only thirty-four had done so. A majority of the nation's banks have always remained outside the Federal Reserve System, although the larger banks have usually been members. The Federal Reserve System largely corrected the faults to which the National Banking System had fallen prey. Admittedly, the Federal Reserve had its faults and did not live up to expectations. Nevertheless, the nation's commercial banks had a policy-directing head and a refuge in distress to a greater degree than they had ever had before. Thus ended the need for the Independent Treasury System, which finally wound up its affairs in 1921.

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Only a few national banks gave up their charters for state ones in order to avoid joining the Federal Reserve System. However, during World War I, many state banks became members of the system. All banks helped sell Liberty bonds and bought short-term Treasuries between bond drives, which was one reason for a more than doubling of the money supply and also of the price level from 1914 to 1920. A major contributing factor for these doublings was the sharp reduction in reserves required under the new Federal Reserve System as compared with the pre-1914 National Banking System.

By 1921 there were 31,076 banks, the all-time peak. Every year, local crop failures, other disasters, or simply bad management wiped out several hundred banks. By 1929 the number of banks had declined to 25,568. Admittedly, mergers eliminated a few names, and the growth of branch, group, or chain banking provided stability in some areas. Nevertheless, the 1920s are most notable for stock market speculation. Several large banks had a part in this speculation, chiefly through their investment affiliates. The role of investment adviser gave banks great prestige until the panic of 1929, when widespread disillusionment from losses and scandals brought them discredit. --------KNOWLEDGEFINANCIAL.COM

The 1930s witnessed many reforms growing out of the more than 9,000 bank failures between 1930 and 1933 and capped by the nationwide bank moratorium of 6–9 March 1933. To reform the commercial and central banking systems, as well as to restore confidence in them, Congress passed two major banking laws between 1933 and 1935. These laws gave the Federal Reserve System firmer control over the banking system. They also set up the Federal Deposit Insurance Corporation to insure bank deposits, and soon all but a few hundred small banks belonged to it. That move greatly reduced the number of bank failures. Other changes included banning investment affiliates, prohibiting banks from paying interest on demand deposits, loosening restrictions against national banks' having branches and making real estate loans, and giving the Federal Reserve Board the authority to raise member bank legal reserve requirements against deposits. As a result of the Depression, the supply of commercial loans dwindled, and interest rates fell sharply. Consequently, banks invested more in federal government obligations, built up excess reserves, and imposed service charges on checking accounts. The 1933–1934 devaluation of the dollar, which stimulated large imports of gold, was another cause of those excess reserves.

During World War II, the banks again helped sell war bonds. They also converted their excess reserves into government obligations and dramatically increased their own holdings of these. Demand deposits more than doubled. Owing to bank holdings of government obligations and to Federal Reserve commitments to the treasury, the Federal Reserve had lost its power to curb bank-credit expansion. Price levels nearly doubled during the 1940s.

In the Federal Reserve-treasury "accord" of March 1951, the Federal Reserve System regained its freedom to curb credit expansion, and thereafter interest rates crept upward. That development improved bank profits and led banks to reduce somewhat their holdings of federal government obligations. Term loans to industry and real estate loans increased. Banks also encountered stiff competition from rapidly growing rivals, such as savings and loan associations and personal finance companies. On 28 July 1959, Congress eliminated the difference between reserve city banks and central reserve city banks for member banks. The new law kept the same reserve requirements against demand deposits, but it permitted banks to count cash in their vaults as part of their legal reserves.

Interest rates rose spectacularly all during the 1960s and then dropped sharply in 1971, only to rise once more to 12 percent in mid-1974. Whereas consumer prices had gone up 23 percent during the 1950s, they rose 31 percent during the 1960s—especially toward the end of the decade as budget deficits mounted—and climbed another 24 percent by mid-1974. Money supply figures played a major role in determining Federal Reserve credit policy from 1960 on.

Money once consisted largely of hard coin. With the coming of commercial banks, it came also to include bank notes and demand deposits. The difference, however, between these and various forms of "near money"—time deposits, savings and loan association deposits, and federal government E and H bonds—is slight. Credit cards carry the confusion a step further. How does one add up the buying power of money, near money, and credit cards? As new forms of credit became more like money, it was increasingly difficult for the Federal Reserve to regulate the supply of credit and prevent booms. --------KNOWLEDGEFINANCIAL.COM

Since 1970 banking and finance have undergone nothing less than a revolution. The structure of the industry in the mid-1990s bore little resemblance to that established in the 1930s in the aftermath of the bank failures of the Great Depression. In the 1970s and 1980s, what had been a fractured system by design became a single market, domestically and internationally. New Deal banking legislation of the Depression era stemmed from the belief that integration of the banking system had allowed problems in one geographical area or part of the financial system to spread to the entire system. Regulators sought, therefore, to prevent money from flowing between different geographical areas and between different functional segments. These measures ruled out many of the traditional techniques of risk management through diversification and pooling. As a substitute, the government guaranteed bank deposits through the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation.

In retrospect, it is easy to see why the segmented system broke down. It was inevitable that the price of money would vary across different segments of the system. It was also inevitable that borrowers in a high-interest area would seek access to a neighboring low-interest area—and vice versa for lenders. The only question is why it took so long for the pursuit of self-interest to break down regulatory barriers. Price divergence by itself perhaps was not a strong enough incentive. Rationing of credit during tight credit periods probably was the cause of most innovation. Necessity, not profit alone, seems to have been the cause of financial innovation.

Once communication between segments of the system opened, mere price divergence was sufficient to cause flows of funds. The microelectronics revolution enhanced flows, as it became easier to identify and exploit profit opportunities. Technological advances sped up the process of market unification by lowering transaction costs and widening opportunities. The most important consequence of the unification of segmented credit markets was a diminished role for banks. Premium borrowers found they could tap the national money market directly by issuing commercial paper, thus obtaining funds more cheaply than banks could provide. In 1972 money-market mutual funds began offering shares in a pool of money-market assets as a substitute for bank deposits. Thus, banks faced competition in both lending and deposit-taking—competition generally not subject to the myriadregulatory controls facing banks.

Consolidation of banking became inevitable as its functions eroded. The crisis of the savings and loan industry was the most visible symptom of this erosion. Savings and loans associations (S&Ls) had emerged to funnel household savings to residential mortgages, which they did until the high interest rates of the inflationary 1970s caused massive capital losses on long-term mortgages and rendered many S&Ls insolvent by 1980. Attempts to re-gain solvency by lending cash from the sale of existing mortgages to borrowers willing to pay high interest only worsened the crisis, because high-yield loans turned out to be high risk. The mechanisms invented to facilitate mortgage sales undermined S&Ls in the longer term as it became possible for specialized mortgage bankers to make mortgage loans and sell them without any need for the expensive deposit side of the traditional S&L business.

Throughout the 1970s and 1980s, regulators met each evasion of a regulatory obstacle with further relaxation of the rules. The Depository Institutions Deregulation and Monetary Control Act (1980) recognized the array of competitors for bank business by expanding the authority of the Federal Reserve System over the new entrants and relaxing regulation of banks. Pressed by a borrowers' lobby seeking access to low-cost funds and a depositors' lobby seeking access to high money-market returns, regulators saw little choice but capitulation. Mistakes occurred, notably the provision in the 1980 act that extended deposit insurance coverage to $100,000, a provision that greatly increased the cost of the eventual S&L bailout. The provision found its justification in the need to attract money to banks. The mistake was in not recognizing that the world had changed and that the entire raison d'être of the industry was disappearing. ------KNOWLEDGEFINANCIAL.COM

Long-term corporate finance underwent a revolution comparable to that in banking. During the prosperous 1950s and 1960s, corporations shied away from debt and preferred to keep debt-equity ratios low and to rely on ample internal funds for investment. The high cost of issuing bonds—a consequence of the uncompetitive system of investment banking—reinforced this preference. Usually, financial intermediaries held the bonds that corporations did issue. Individual owners, not institutions, mainly held corporate equities. In the 1970s and 1980s, corporations came to rely on external funds, so that debt-equity ratios rose substantially and interest payments absorbed a much greater part of earnings. The increased importance of external finance was itself a source of innovation as corporations sought ways to reduce the cost of debt service. Equally important was increased reliance on institutional investors as purchasers of securities. When private individuals were the main holders of equities, the brokerage business was uncompetitive and fees were high, but institutional investors used their clout to reduce the costs of buying and selling. Market forces became much more important in finance, just as in banking.

Institutional investors shifted portfolio strategies toward equities, in part to enhance returns to meet pension liabilities after the Employment Retirement Income Security Act (1974) required full funding of future liabilities. Giving new attention to maximizing investment returns, the institutional investors became students of the new theories of rational investment decision championed by academic economists. The capital asset pricing model developed in the 1960s became the framework that institutional investors most used to make asset allocations.

The microelectronics revolution was even more important for finance than for banking. Indeed, it would have been impossible to implement the pricing model without high-speed, inexpensive computation to calculate optimal portfolio weightings across the thousands of traded equities. One may argue that computational technology did not really cause the transformation of finance and that increased attention of institutional investors was bound to cause a transformation in any event. Both the speed and extent of transformation would have been impossible, however, without advances in computational and communications technologies.

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OCTOBER 2008 ----- WASHINGTON - The government will buy an ownership stake in a broad array of American banks for the first time since the Great Depression, Treasury Secretary Henry Paulson said late Friday, announcing the historic step after stock markets jolted still lower around the world despite all efforts to slow the selling stampede

Separately, the U.S. and the globe's other industrial powers pledged to take "decisive action and use all available tools" to prevent a worldwide economic catastrophe. ---------KNOWLEDGEFINANCIAL.COM

"This is a period like none of us has ever seen before," declared Paulson at a rare Friday night news conference. He said the government program to purchase stock in private U.S. financial firms will be open to a broad array of institutions, including banks, in an effort to help them raise desperately needed money.

The administration received the authority to take such direct action in the $700 billion economic rescue bill that Congress passed and President Bush signed last week.

Earlier Friday, stock prices hurtled downward in the United States, Europe and Asia, even as President Bush tried to reassure Americans and the world that the U.S. and other governments were aggressively addressing what has become a near panic.

A sign of how bad things have gotten: A drop of 128 points in the Dow Jones industrials was greeted with sighs of relief after the index had plummeted much further on previous days. The week ended as the Dow's worst ever, with the index down an incredible 40.3 percent since its record close almost exactly one year earlier, on Oct. 9. 2007.

Investors suffered a paper loss of $2.4 trillion for the week, as measured by the Dow Jones Wilshire 5000 index, and for the past year the losses have totaled $8.4 trillion.

It was even worse overseas on Friday. Britain's FTSE index ended below the 4,000 level for the first time in five years; Germany's DAX fell 7 percent and France's CAC-40 finished down 7.7 percent. Japan's benchmark Nikkei 225 index fell 9.6 percent, also hitting a five-year low. For the week, the Nikkei lost nearly a quarter of its value. Russia's market never even opened.

Paulson announced the administration's new effort to prop up banks at the conclusion of discussions among finance officials of the Group of Seven major industrialized countries. That group endorsed the outlines of a sweeping program to combat the worst global credit crisis in decades.

Earlier this week, Britain had moved to pour cash into its troubled banks in exchange for stakes in them — a partial nationalization.

Paulson said the U.S. program would be designed to complement banks' own efforts to raise fresh capital from private sources. The government's stock purchases will be of nonvoting shares so it will not have power to run the companies. -------------KNOWLEDGEFINANCIAL.COM

The purchase of stakes in companies would be in addition to the main thrust of the $700 billion rescue effort, which is to buy bad mortgages and other distressed assets from financial institutions. The aim is to unthaw frozen credit, get banks to resume more normal lending operations and stave off severe problems for businesses and everyday Americans alike.

It would mark the first time the government has taken equity ownership in banks in this manner since a similar program was employed during the Depression.

In 1989, the government created the Resolution Trust Corp. to deal with the aftermath of the savings and loan crisis. It disposed of the assets of failed savings and loans.

Paulson and Federal Reserve Chairman Ben Bernanke met with their counterparts from the world's six other richest countries late in the day as the rout of financial markets sped ahead despite earlier dramatic rescue efforts in the U.S. and abroad.

In a statement at the end of that meeting, the G7 officials vowed to protect major banks and to prevent their failure. They also committed to working to get credit flowing more freely again, to support the efforts of banks to raise money from both public and private sources, to bolster deposit insurance and to revive the battered mortgage financing market.

They did not provide specifics beyond that five-point framework.

At the White House earlier in the day, Bush said, "We're in this together and we'll come through this together." He added, "Anxiety can feed anxiety, and that can make it hard to see all that's being done to solve the problem."

He made it clear the United States must work with other countries to battle the worst financial crisis that has jolted the world economy in more than a half-century. -----------KNOWLEDGEFINANCIAL.COM

"We've seen that problems in the financial system are not isolated to the United States," he said. "So we're working closely with partners around the world to ensure that our actions are coordinated and effective."

Fear has tightened its grip on investors worldwide even as the United States and other countries have taken a series of radical actions including an unprecedented, coordinated interest rate cuts by the Federal Reserve and other major central banks.

Besides the United States, the other members of the G7 meeting in Washington are Japan, Germany, Britain, France, Italy and Canada. Finance officials also planned to meet with Bush Saturday at the White House.

"We are in a development where the downward spiral is picking up speed," said Germany's Finance Minister Peer Steinbrueck, who wanted to see an orchestrated response among the G7.

So did French Finance Minister Christine Lagarde, who said a "coordinated, synchronized and rightly timed approach" was needed.

An even larger group of nations — called the G20 — will meet with Paulson on Saturday evening. How the world's finance officials and central bank presidents can better contain the spreading financial crisis also will dominate discussions at the weekend meetings of the 185-nation International Monetary Fund and the World Bank in Washington.

The British, who recently announced a plan to guarantee billions of dollar worth of debt held by major banks, have been pitching that idea to the rest of the G7 members. ---------KNOWLEDGEFINANCIAL.COM

The idea behind all these ideas — as well as bold steps previously announced in recent weeks — is to get credit flowing more freely again.

In the United States, hard-pressed banks and investment firms are drawing emergency loans from the Federal Reserve because they can't get money elsewhere. Skittish investors have cut them off, moving their money into safer Treasury securities. Financial institutions are hoarding whatever cash they have, rather than lending it to each other or customers.

The lending lockup — which is making it harder and more expensive for businesses and ordinary people to borrow money — is threatening to push the United States and the world economy as a whole into a deep and painful recession.

In Europe, governments have moved to protect nervous bank depositors. Germany pledged to guarantee all private bank savings and CDs in the country, and Iceland and Denmark followed suit. Ireland went even further by also guaranteeing Irish banks' debts. The United States will temporarily boost deposit insurance from $100,000 to $250,000 in cases where its banks or savings and loans fail.

The Fed, meanwhile, has repeatedly tapped its Depression-era authority to be a lender of last resort, not only to financial institutions but also to other types of companies. Earlier this week, the Fed said it would buy massive amounts of companies' debts, in another unprecedented effort to break through the credit clog.

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Top 6 Biggest U.S. Government Financial Bailouts In History!The passage into U.S. law on October 3, 2008, of the $700 billion financial-sector rescue plan is the latest in the long history of U.S. government bailouts that go back to the Panic of 1792,when the federal government bailed out the 13 United States, which were over-burdened by their debt from the Revolutionary War

Until 1863, US banks were regulated by the states. The Federal Government had twice established a national bank, but abandoned both efforts. In 1863, the Civil War had been raging for two years, and the Federal Government was desperately short of cash. Secretary of the Treasury Salmon P. Chase came up with an innovative source of financing.

The Federal Government would charter national banks that would have authority to issue their own currency so long as it was backed by holdings in US Treasury bonds. The idea was implemented as the National Currency Act, which was completely rewritten two years later as the National Banking Act. The act formed the Office of the Comptroller of the Currency (OCC) with authority to charter and examine national banks. In this way, a dual system of banking was launched, with some banks chartered and regulated by the states and others chartered and regulated by the OCC.

As a response to the financial panic of 1907, the 1913 Federal Reserve Act formed the Federal Reserve System (the Fed) as a central bank and lender of last resort. The system included several regional Federal Reserve Banks and a seven-member governing board. National banks were required to join the system, and state banks were welcome to. Federal Reserve notes were introduced as a national currency whose supply could be managed by the Fed. The notes were issued to reserve banks for subsequent transmittal to banking institutions as needed. The new notes supplanted the OCC's purpose related to currency, but that organization continued to be the primary regulator of national banks.

Prior to 1933, US securities markets were largely self-regulated. As early as 1922, the New York Stock Exchange (NYSE) imposed its own capital requirements on member firms. Firms were required to hold capital equal to 10% of assets comprising proprietary positions and customer receivables.

By 1929, the NYSE capital requirement had developed into a requirement that firms hold capital equal to:

5% of customer debits;

a minimum 10% on proprietary holdings in Treasury or municipal bonds;

30% on proprietary holdings in other liquid securities; and

100% on proprietary holdings in all other securities.

During October 1929, the US stock market crashed, losing 20% of its value. The carnage spilled into the US banking industry where banks lost heavily on proprietary stock investments. Fearing that banks would be unable to repay money in their accounts, depositors staged a “run” on banks. Thousands of US banks failed.

BANKING HISTORY CONTINUE... --------------KNOWLEDGEFINANCIAL.COM

Glass-Steagall also formed the Federal Deposit Insurance Corporation (FDIC) to provide deposit insurance for commercial banks. All member banks of the Federal Reserve were required to participate. Other banks were welcome to participate upon certification of their solvency. The FDIC was funded with insurance premiums paid by participating banks. Deposits were insured up to USD 2,500—if a bank failed, the FDIC would make whole depositors for losses on deposits up to USD 2,500. That insurance level has since been increased to USD 100,000.

Two other acts addressed the securities markets. The 1933 Securities Act focused on primary markets, ensuring disclosure of pertinent information relating to publicly offered securities. The 1934 Securities Exchange Act focused on secondary markets, ensuring that parties who trade securities—exchanges, brokers and dealers—act in the best interests of investors. Certain securities—including US Treasury and municipal debt—were exempted from most of these acts' provisions.

The Securities Exchange Act established the Securities and Exchange Commission (SEC) as the primary regulator of US securities markets. In this role, the SEC gained regulatory authority over securities firms. Called broker-dealers in US legislation, these include investment banks as well as non-banks that broker and/or deal non-exempt securities. The 1938 Maloney Act clarified this role, providing for self regulating organizations (SRO’s) to provide direct oversight of securities firms under the supervision of the SEC. SRO’s came to include the National Association of Securities Dealers (NASD) as well as national and regional exchanges. Commercial banks continued to be regulated by the OCC or state regulators depending upon whether they had federal or state charters.

In 1938, the Securities Exchange Act was modified to allow the SEC to impose its own capital requirements on securities firms, so the SEC started to develop a Net Capital Rule. Its primary purpose was to protect investors who left funds or securities on deposit with a securities firm. In 1944, the SEC exempted from this capital rule any firm whose SRO imposed more comprehensive capital requirements. Capital requirements the NYSE imposed on member firms were deemed to meet this criteria.

Mutual funds, and especially closed-end mutual funds, were hit hard in the 1929 crash. A number of abuses came to light—some closed-end funds had been little more than Ponzi schemes—prompting Congress to pass the 1940 Investment Company Act regulating mutual funds. With a few exceptions—which encompass most of today's hedge funds—this granted the SEC regulatory authority over investment companies. Congress also passed the 1940 Investment Advisers Act, regulating the relationship between mutual funds and their investment managers.

Between 1967 and 1970, the NYSE experienced a dramatic increase in trading volumes. Securities firms were caught unprepared, lacking the technology and staff to handle the increased workload. Back offices were thrown into confusion trying to process trades and maintain client records. Errors multiplied, causing losses. For a while, this “paperwork crisis” was so severe that the NYSE reduced its trading hours and even closed one day a week. In 1969, the stock market fell just as firms were investing heavily in back office technology and staff. Trading volumes dropped, and the combined effects of high expenses, decreasing revenues and losses on securities inventories proved too much for many firms. Twelve firms failed, and another 70 were forced to merge with other firms. The NYSE trust fund, which had been established in 1964 to compensate clients of failed member firms, was exhausted.

The US stock market declined through 1969. ----------KNOWLEDGEFINANCIAL.COM

In the aftermath of the paperwork crisis, Congress founded the Securities Investor Protection Corporation (SIPC) to insure client accounts at securities firms. It also amended the Securities Exchange Act to require the SEC to implement regulations to safeguard client accounts and establish minimum financial responsibility requirements for securities firms.

As a backdrop to these actions, it came to light that the NYSE had failed to enforce its own capital requirements against certain member firms at the height of the paperwork crisis. With its trust fund failing, it is understandable that the NYSE didn’t want to push more firms into liquidation. This inaction marked the end of SROs setting capital requirements for US securities firms.

In 1975, the SEC updated its capital requirements, implementing a Uniform Net Capital Rule (UNCR) that would apply to all securities firms trading non-exempt securities. As with earlier capital requirements, the capital rule’s primary purpose was to ensure that firms had sufficient liquid assets to meet client obligations. Firms were required to detail their capital calculations in a quarterly Financial and Operational Combined Uniform Single (FOCUS) report.

During the Great Depression, the Fed had implemented Regulation Q that, among other things, capped the interest rates commercial banks could offer on savings account deposits. The intent was to prevent bidding wars between banks trying to grow their depositor bases. Rising interest rates during the 1970s contributed to a migration of larger institutional deposits to Europe, where interest rates were not limited by Regulation Q. The emergence of money market funds, which pooled cash to invest in money market instruments, caused further erosion of bank deposits.

In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act. Among other things, this terminated the Regulating Q ceiling on savings account interest rates, effective in 1986. In response to this and an ongoing decline in bank capital ratios, bank regulators implemented minimum capital requirements for banks. There was some debate about what should be included in a bank's capital. This was resolved by defining two classes of capital. A bank's primary capital would be a bank's more permanent capital. It was defined as owners' equity, retained earnings, surplus, various reserves and perpetual preferred stock and mandatory convertible securities. Secondary capital, which was more transient, included limited-life preferred stock and subordinated notes and debentures. In 1981, the Fed and OCC implemented one capital requirement, and the FDIC implemented another. Generally, these specified minimum primary capital ratios of between 5% and 6%, depending on a bank's size.

Because these requirements were based on a bank's assets, they were particularly susceptible to regulatory arbitrage. Various modifications were made to the primary capital requirements, but it was soon clear that basing capital requirements on a capital ratio was unworkable. In 1986, the Fed approached the Bank of England and proposed the development of international risk-based capital requirements. This led to the 1988 Basel Accord, which replaced the asset-based primary capital requirements for US commercial banks. The concepts of primary and secondary capital were incorporated into the new accord as tier 1 and tier 2 capital.

As time went on, the Glass-Steagal separation of investment and commercial banking was gradually eroded. Some of this stemmed from regulatory actions. Much of it stemmed from market developments not anticipated by the act.

BANKING HISTORY CONTINUE... ------------KNOWLEDGEFINANCIAL.COM

Glass-Steagall did not prevent commercial banks from engaging in securities activities overseas. By the mid 1980s, US commercial banks such as Chase Manhatten, Citicorp and JP Morgan had thriving overseas securities operations. Currencies were not securities under the Glass-Steagall Act, but since exchange rates were allowed to float in the early 1970s, they have entailed similar market risk.

In 1933, futures markets were small and transacted primarily in agricultural products, so they were not included in the legal definition of securities. Also, depression era legislators did not anticipate the emergence of active OTC derivatives markets, so most derivatives did not fall under any definition of securities. By the early 1990s, commercial banks were taking significant market risks, actively trading foreign exchange, financial futures and OTC derivatives. They did so while enjoying FDIC insurance and membership in the Federal Reserve system. Neither of these benefits was available to the investment banks with whom they were increasingly competing.

Commercial banks focused on the prospect of repealing Glass-Steagal and related legislation. This would open the door to the creation of financial supermarkets that combined commercial banking, investment banking and insurance. Due to the nature of their business, commercial banks generally had more robust balance sheets than investment banks, and they could expect to dominate such a new world. There would be profits from cross-selling deposit taking, lending, investment banking, brokerage, investment management and insurance products to a combined client base. There would also be troublesome conflicts of interest.

While he was chairman of the Federal Reserve, Paul Volker fought efforts to ease the separation between commercial and investment banking. Allen Greenspan replaced Volker in 1987, and he brought with him a more accommodating attitude. Section 20 of the Glass-Steagall Act had always granted modest exemptions allowing commercial banks to engage in limited securities activities as a convenience to clients who used the bank’s other services. ------------KNOWLEDGEFINANCIAL.COM

Tentatively under Volker, but aggressively under Greenspan, the Fed reinterpreted Section 20 to expand that authorization. In various rulings during the late 1980s, the Fed granted certain commercial banks authority under Section 20 to underwrite commercial paper, municipal revenue bonds, mortgage-backed securities and even corporate bonds. In October 1989, JP Morgan became the first commercial bank to underwrite a corporate bond, floating a USD 30MM bond issue for the Savannah Electric Power Company. A flood of commercial bank underwritings followed.

The Fed also allowed commercial banks to acquire investment bank subsidiaries through which they might underwrite and deal in all forms of securities, including equities. These became known as Section 20 subsidiaries. There were limitations on the use of Section 20 subsidiaries. The most restrictive was a cap on the revenue a commercial bank could derive from securities activities under Section 20. In 1986, the Fed had set this cap at 5%. It was expanded to 10% in 1989 and again in 1996 to 25%.

Congress attempted to repeal Glass-Steagall in 1991 and again in 1995. Both attempts failed, but the stage was set. The Fed had already gutted much of Glass-Steagall. Commercial banks were deriving considerable revenues from investment banking activities. Their lobbyists had arrayed considerable forces in Congress ready to make another attempt. Glass-Steagall was teetering, and all that was needed was for someone to step forward and topple her.

That is what John Reed and Sanford Weill did. Reed was CEO of Citicorp, a large commercial bank holding company. Weill was CEO of Travelers Group, a diverse financial services organization. It had origins in insurance but had recently acquired the two investment banks Salomon and Smith Barney and merged them into a single investment banking subsidiary. In 1998, Reed and Weill merged their firms, forming Citigroup, a financial services powerhouse spanning commercial banking, investment banking and insurance. This was an aggressive move that could easily have been blocked by regulators.

A permissive Fed was supportive of the deal, which forced the hand of Congress. In 1956, Congress had passed the Bank Holding Company Act, which had supplemented Glass-Steagall by limiting the services commercial banks could offer clients. The Citicorp-Travelers merger violated the 1956 act, but there was a loophole. The Holding Company Act allowed for a two-year review period—with an optional extension to five years—before the Fed would have to act. The newly formed Citigroup was the world's largest financial services organization, but it was operating under a five-year death sentence. If Congress didn't pass legislation during those five years, Citigroup would have to divest some of its businesses.

Pressure on Congress was immense. In 1999, they passed the Financial Services Modernization Act, and President Clinton signed it into law. The act is also known for the names of its sponsors—the Gramm-Leach-Bliley Act—but detractors have called it the Citigroup Authorization Act. This sweeping legislation finally revoked the Glass-Steagall separation of commercial and investment banking. It also revoked the 1956 Bank Holding Company Act. It permitted the creation of financial holding companies (FHCs) that may hold commercial banks, investment banks and insurance companies as affiliated subsidiaries. Those subsidiaries may sell each others products. Within a year of the new act's passage, five hundred bank holding companies formed FHCs. ---------------KNOWLEDGEFINANCIAL.COM

Although it was sweeping, the Financial Services Modernization Act was, in some respects, a half measure. It dramatically transformed the financial services industry, but it did little to transform the regulatory framework. Prior to the act, commercial banks, investment banks and insurance companies had been separate, and they had oversight from separate regulators—the Fed and OCC for commercial banks, the SEC for investment banks, and state regulators for insurance companies. Who would now oversee the new FHCs that combined all three industries? The answer is no one. The act adopted a "functional" approach to regulation. The Fed and OCC now regulate the commercial banking functions of FHCs. The SEC regulates their investment banking functions. State insurance regulators regulates their insurance functions. The act has opened the door to abuses across functions, but no regulator is clearly positioned to identify and address these.

At the same time that Glass-Steagall was being torn down, dramatic growth in the OTC derivatives market led to concern that there was no regulator with clear authority to oversee that market. A 1982 amendment to the Securities Exchange Act specified that options on securities or baskets of securities were to be regulated by the SEC. This left structures such as forwards and swaps outside the SEC's jurisdiction. It also excluded derivatives on interest rates or foreign exchange. A regulator with authority most relevant to these derivatives was one whose original purpose was unrelated to financial markets. This was the Commodity Futures Trading Commission (CFTC).

Congress formed the CFTC under the 1974 Commodity Exchange Act (CEA). It had exclusive jurisdiction to regulate commodity futures and options. Whether this authority encompassed OTC financial derivatives was not legislatively clear and motivated several law suits.

As a debate raged over how OTC derivatives should be regulated—or if they even should be regulated—there was pressure for the the CFTC to act. Because its authority was not clear, the CFTC hesitated, and market participants were generally opposed to the CFTC intervening. Position papers were written by industry groups and government agencies. Inevitably, there were some turf skirmishes as different regulatory agencies tried to position themselves for a role in any new regulatory regime. A strong argument against increased regulation of OTC derivatives was that it would drive the market overseas—as had happened 20 years earlier to the market for USD deposits.

Finally, Congress acted in 2000 by passing the Commodity Futures Modernization Act (CFMA). This amended the 1974 Commodity Exchange Act, exempting all OTC derivatives. The CFTC was not to regulate OTC derivatives. The market was to remain largely unregulated.

Overheated technology stocks formed a bubble that collapsed during 2000. In 2001, the broader market also fell sharply. On September 11 of that year, terrorists hijacked airliners, slamming two of them into New York's World Trade Center. Another hit the Pentagon in Washington, and a fourth fell in a Pennsylvania field. With the terrorist attacks, the bad news seemed to accelerate. Within weeks, the Wall Street Journal was reporting on a brewing scandal at energy trading powerhouse Enron. -----KNOWLEDGEFINANCIAL.COM

The firm had been using accounting gimmicks and outright deception to inflate profits and hide debt. In December, it filed for bankruptcy—the largest in US history. In 2002, that record was broken by the bankruptcy of telecommunications firm WoldCom, which had inflated its 2000-2001 income by a whopping USD 74.4 billion. Enron and WorldCom were just the two most prominent in a slew of bankruptcies and accounting scandals, which included Global Crossing, Tyco, Rite Aid, Xerox, and others. In 2002, Accounting firm Arthur Andersen was convicted of a single charge stemming from its lackluster auditing of Enron. That action forced Andersen, one of the largest and most respected auditors in the world, to go out of business. In 2005, the US Supreme Court overturned the decision, concluding that the presiding judge had given the jury faulty instructions. This decision came too late to save Arthur Andersen.

There was plenty of blame to go around. Corporate executives had cooked books while lining their pockets. Analysts at investment banks had recommended stocks they knew were dogs in a quid pro quo that ensured banking business from those same firms. Accounting firms had been cross-selling consulting services to audit clients. Increasingly, their auditors had shied away from challenging management of firms so as to not jeopardizing those lucrative consulting engagements.